Table of Contents
- Risks Involved in Real Estate Investments
a. Physical Asset Risk
b. Geographic or Market Risk
c. Development Risk
d. Vacancy Risk (Leasing Risk)
e. Tenant Risk
f. Cap Rate Risk
g. Debt Risk
h. Sponsor Risk
Risk is an inevitable part of any real estate investment deal. While these risks are often out of investors’ control, it is still important to understand the various types of risks involved and how they impact property investment. In this article, we cover the various sources of risk in real estate investment deals, and how investors can mitigate these risks.
Risks Involved in Real Estate Investments
1) Physical Asset Risk
Physical asset risk is the risk that an investment property will incur unplanned costs due to its physical condition. This is especially true for older properties, properties in poor condition, or properties that have not been well-maintained. These properties may require costly repairs that impact the profitability of the investment.
Investors can reduce physical asset risk by doing their due diligence before closing a deal, such as by engaging a valuer, and negotiate the price or terms of the investment based on the property’s condition, including any physical defects.
2) Geographic or Market Risk
The location of a property also significantly affects its performance and the level of risk involved in the investment. The geographic location determines the population, demographics, and job growth within the property’s market, all of which impacts the size of the tenant pool and associated demand.Primary markets with a larger tenant pool allow for some buffer in the event of a market downturn, but may also come with higher prices.
The market in which an investment property is located is also a key factor. High occupancy rates and steadily growing rental prices are good indicators of a strong market. Market risk factors include a boom in new developments within the market or a slowing economy, which can both affect the supply and demand for property and land.
3) Development Risk
When a property requires significant development or redevelopment, there is development risk associated with it, which may come in the form of construction risk and entitlement risk.
Construction risk is the risk that the project will not be completed within the expected time frame, incur higher construction costs, or reveal defects to the physical property. Therefore, it is important to ensure that the sponsor has sufficient experience in construction project management if the investment includes a development aspect.
Entitlement risk is most common in new development projects, which often require an extended entitlement process where construction approvals are obtained. This is required before construction is allowed to commence. The length of time before approval is granted is often variable to a large extent and can push back construction timelines, impacting the profitability of the property investment.Sign Up at RealVantage
4) Vacancy Risk (Leasing Risk)
In a property with existing vacancies, the sponsor usually expects to lease the units out to fill up the property over time. With leasing risk, the units may not get leased out within the set time frame, with units remaining vacant for extended periods.
Vacancy risk can be mitigated by setting aside a reasonable amount of time and money as a buffer, which can be drawn upon in the event that the vacancies are not filled. This ensures that the costs of marketing and incentivising potential tenants to sign agreements, as well as the costs of maintaining the investment property, are covered.
5) Tenant Risk
Tenants of income-generating investment properties can pose a degree of risk for investors, in the form of rent roll quality and rollover risk.
Rent roll quality depends on the stability, creditworthiness, and number of tenants of an investment property. Large multinational companies with high volumes of sales contribute to higher rent roll quality since they tend to be more reliable tenants than smaller businesses. In addition, an investment property with a single tenant is generally riskier than a property with multiple tenants occupying a smaller percentage of the total property area. With a single tenant, the occupancy rate is usually either 100% or 0%, which may lead to unpredictable income flow if the tenant leaves. Tenant risk can be mitigated by diversifying tenants so that the departure of a single tenant does not significantly impact the profitability of the property, or by signing longer lease terms.
Tenant risk also comes in the form of rollover risk, which refers to the risk that tenants leave at the end of their lease without renewing or ‘rolling over’ the lease, or that no replacement tenants are found, or even that new leases are on less favourable terms than before for the landlord. Rollover risk can be mitigated by having periodic tenant meetings to determine their plans for the lease, and ensuring that there is sufficient time and budget for the marketing process if new tenants need to be found..
6) Cap Rate Risk
Cap rate risk can pose substantial risks to a real estate asset’s selling price. This is because a relatively small change in the cap rate can have a disproportionate impact on the property value and the profitability of the investment.
In order to mitigate this risk, investors should look at the cap rate when entering into a real estate investment (the ‘entry cap rate’), as well as the projected cap rate at the end of the intended investment period (the ‘exit cap rate’), and ensure that they are not too low, and that the projections do not show too much of a decrease in the cap rate from entry to exit, which may at times be overly aggressive in order to project higher returns.
7) Debt Risk
Taking on debt to finance a real estate investment is a common step in the investment process. However, it is important to understand the risks associated with taking on such debt and the potential foreclosure that may arise as a result of over leveraging risk, debt maturity risk, or both
Over leverage is when a property takes on more debt than it can service. While banks typically do not lend below a debt coverage service ratio of 1.0, this can occur when the property loses tenants to the point that the interest or amortisation payments required exceeds the income being generated by the property.
Read Also: What is Debt-to-Equity (D/E) Ratio and What is it Used for?
Read Also: What is Loan-To-Cost (LTC) Ratio?
Debt maturity risk occurs when a property’s debt matures at a time when the property’s net operating income is lower than expected, or when the market is down. If debt matures at such a time, investors may face difficulty in obtaining a new loan that covers the amount of the outstanding debt. This puts the investors at risk of defaulting, and is a significant contributor to failed property investments during a financial crisis.
8) Sponsor risk
The expertise and skill of the operator, developer, or lender plays an important role in whether a Sponsor can successfully plan out a property investment, and achieve target returns. Sponsor risk can be in the form of asset management risk or property management risk.
The asset manager has the responsibility to carry out the strategic business plan for the real estate investment. Asset management risk refers to the potential risk of the asset manager not being able to successfully translate the business plan into a desirable outcome.
Property management also plays an important role in executing a property’s business plan, depending on the real estate asset class. In asset classes such as hospitality or storage facilities, where day-to-day customer service is pivotal to the property’s performance, property management can have a direct impact on the property’s success.
RealVantage is a co-investment platform that allows investors to co-invest alongside other investors. This can effectively lower the initial investment required for various types of real estate deals, reducing capital risk. RealVantage is run by experienced industry experts who have access to quality real estate deals, providing investors with strong risk-adjusted returns. Investors are able to leverage on the team’s in-depth knowledge of the industry and hassle-free asset management services for real estate investments.
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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.